Ahoy! – “Wear and Tear” and “Manufacturing Defect” Exclusions in Yacht Insurance Policies Upheld in Recent Decisions From the First and Eleventh Circuits

Both the First and Eleventh Circuit Courts of Appeals have recently rejected arguments seeking to limit the application of “wear and tear” and “manufacturing defect” exclusions in yacht insurance policies. In Miele v. Certain Underwriters at Lloyd’s of London, — Fed. Appx. —, 2014 WL 998184 (11th Cir. March 17, 2014), the insured’s 32-foot vessel sank while docked because water entered through what a surveyor concluded was a “degraded and rotten” air conditioning hose, which cause was not disputed. Underwriters denied coverage under the insured’s yacht insurance policy based upon an exclusion for “losses or damages arising (whether incurred directly or indirectly) from … the costs of repairs or replacing any part of Your Boat by reason of wear and tear, gradual deterioration ….” In the insured’s suit against Underwriters, the United States District Court for the Southern District of Florida granted summary judgment to Underwriters.

On appeal, the insured argued that the exclusion was ambiguous and should be limited to excluding only the cost of replacing the air conditioning hose and not the cost of replacing the entire boat if a part failed and caused a sinking. The Eleventh Circuit disagreed, concluding that the exclusion was unambiguous and broader than the insured argued. In its view, the exclusion applied to all damages arising from the need to replace a single part due to wear and tear. The Eleventh Circuit agreed with the district court’s reasoning that a vessel is nothing but a sum of all its parts and that the exclusion bars coverage for any single part or collection of parts where the damages are caused by wear and tear of any part. In the case at hand, “the need to replace one part due to wear and tear indirectly gave rise to a need to replace all parts.” Unfortunately for the insured, the fact that the entire vessel was damaged made no difference in the application of the exclusion.

The issue before the First Circuit in Ardente v. Standard Fire Ins. Co., 744 F.3d 815 (March 12, 2014) was whether balsa wood – incorporated in installation holes in a yacht – were a “hidden flaw inherent in the material” within the meaning of the latent defect exception to a yacht insurance policy’s manufacturing defect exclusion. The exclusion barred coverage for “loss or damage caused by or resulting from defects in manufacture, including defects in construction, workmanship and design other than latent defects.” The term “latent defect” was defined as “a hidden flaw inherent in the material existing at the time of the original building of the yacht, which is not discoverable by ordinary observation or methods of testing.”

The insured’s yacht sustained water damage to the hull, which was traced to water seeping into balsa wood surrounding installation holes and then spreading throughout the hull. Normally, the material surrounding installation holes is solid laminate, which is water proof. But here, the installation holes were surrounded by balsa wood, which is not water proof. The insurer denied coverage for the damage on the ground that it fell within the manufacturing defect exclusion. In the insured’s suit against the insurer, the United States District Court for the District of Rhode Island granted summary judgment to the insured on its breach of contract claim. Because, in the district court’s view, “inherent” meant something that was characteristic of the material and a “flaw” was the opposite, there could be no such thing as an inherent flaw. Finding that the phrase “flaw inherent in the material” was ambiguous, the district court therefore interpreted “latent defect” to include the flawed use of unflawed material. According to the district court, “The use of balsa wood in these areas was a flaw in the construction of the yacht, even if it was not a flaw in the underlying material itself.” Thus, the use of balsa wood – which normally absorbs water – was such a flawed use and therefore within the exception to the exclusion.

While recognizing that the policy’s definition of “latent defect” was “not a model of precision” and redundant (in that it simultaneously used the terms hidden, not discoverable, and inherent), the First Circuit disagreed that the term was self-contradictory. The First Circuit found that the district court failed to give the term its plain, everyday meaning: flaws in the material used to build the boat that were not noticeable. It found further that the district court’s remedy of the purported ambiguity was improper. Although a canon of policy interpretation is to avoid surplusage, or redundant terms, that rule should not be applied, the First Circuit cautioned, if it renders the policy ambiguous. In this case, the district court effectively changed the language of the exception to require a “hidden flaw in the yacht,” rather than in the material. Yet this interpretation did not address the perceived redundancy, which the First Circuit suggested could have been more appropriately remedied by striking the word inherent. Ultimately, applying the plain meaning of the exclusion, the First Circuit directed that summary judgment be entered in favor of the insurer.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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